Eighteen months after MiFID II rules to unbundle research payments from executions have been in force in Europe, U.S. asset managers are dealing with uncertainty around paying for research and how to compete with global firms that adopt the EU rules.

Many US asset managers are evaluating the need for increased transparency in their own research payment models, but they are waiting for further guidance from the Securities and Exchange Commission (SEC).

The SEC issued three no-action letters in 2017 allowing the sell side to accept a check from European clients without violating U.S. rules. Those no action letters expire in July of 2020

“Clearly a lot of businesses are looking at what’s happening in Europe and asking is it necessary to do this; is it a good idea; do my clients and consultants want me to make that change,”  said a global bank’s sell-side research executive on the MiFID II panel at Tabb Group’s Equities 2019 conference.

Buy-side and sell-side market participants debated the pros and cons of MiFID II’s research unbundling rules at the TABB equities conference in June. In particular, market participants discussed the impact of asset managers opting to pay for research out of their own P&Ls,  the reduction in research budgets and the shrinkage of commission wallets that has followed.

“On the benefit side, there are fewer conflicts, greater accountability, more transparency, and better focus on execution,” said Larry Tabb, founder and research chairman of Tabb Group in his opening remarks.

On the downside, there’s been almost a 40% cut in the research portion of the commission wallet, said Tabb.  Overall, this amounts to a 30% cut to the complete wallet. “Everything is under pressure,” he said.

About a quarter of US investment firms have an office in the European area and would be affected, according to the sell-side executive.

But what’s making things more complicated is the difference in the US and European rules.

“Although MiFID II is a European regulation that only applies to financial institutions doing business in Europe, there is a widespread movement by investors, especially the larger global managers, to adopt a common process and payment method,” said Campbell Peters, equity analyst at Tabb Group, who moderated the panel.

“Under MiFID II, investment firms must make explicit payments for research rather than bundling payments for brokerage research with trade execution,” explained Peters.

“The challenge is that “accepting a payment In the US puts brokers in breach of the Investment Advisor’s Act unless they register as investment advisors and accept an additional layer of regulation,” said Peters. “This opens up another can of worms,” said Peters.

It is not easy to stay within the dueling transatlantic rules. “Because global asset managers have ringfenced their European operations, they are now flowing 100% of their US equity trading through commission sharing agreements, which segregate trading costs between a research component and an execution component,” said Sandy Bragg, principal at Integrity Research, in Markets Media’s “MiFID II Increases Research Unbundling in U.S.”

Consolidation Under MiFID II

Those contemplating the benefits of MiFID II need to be aware of the results. So far MiFID II has had “far reaching implications” for the way research is priced and paid for, said the sell-side panelist. Over the past few years, the global bank has had pricing conversations with 1,800 investment firms, including 1,100 in Europe.  Sell-side firms have specific commercial agreements with their clients, service level agreements and contracts.

As a result of opting to pay for research themselves, many buy-side firms have slashed the number of research broker providers. A large firm that may have had 200 research providers has cut the number to 150, though that is still a large number.  Since the commissions are just for execution, the number of trading counterparties has shrunk dramatically. Rather than execute via 200 firms, they’re trading with a dozen, said the sell-side executive.

Regulators designed MiFID II with the intention of making financial markets more transparent, fairer and more efficient, said Tabb’s Peters.

But the jury is still out on whether it’s achieved those goals, noted the panelists.

“I don’t think it’s done any of those things,” said the global sell-side panelist. In fact, there are some 40 large asset managers, including the likes of Fidelity and Norges, that contend they unbundled years ago, the sell-side panelist said.

Although thousands of buy-side firms have unbundled, not everyone has done so.  “On the continent, some regulators have a taken a slightly narrower view, so that mutual funds and hedge fund managers don’t have to unbundle,” said the sell-side executive.

Overall, three out of five firms have unbundled, said the sell-side executive. “Europe is a mosaic” where almost everyone in the UK has unbundled except for insurance companies, family offices and sovereign wealth funds. “So, it’s a very uneven playing field,” said the sell-side research executive.

However, the consolidation that’s happening in Europe is going as planned, said a global head trader for a U.S. buy-side firm.  The trader said if he had been in Europe, he would have taken his number of counterparties down to 10 firms and the list of research firms would drop by 30-40%.

The Chicago-based money manager with a London office, said his investment firm is not subject to MiFID II.

“We don’t have to worry about being MiFID compliant unless some of our clients are in MiFID’s scope,” said the head of trading for the long-only firm with $8 billion AUM.

However, the bigger problem is the potential for “organic contagion” where pension funds or institutional accounts or consultants know what’s going on in Europe and ask the U.S. asset manager to adopt that process or approach in the U.S.  “We are not set up as a firm to handle that kind of impact to our bottom line,” said the buy-side trader.  A firm would need to manage $15 billion in assets to absorb the additional expense to pay for research, he estimated.

David vs. Goliath

One of the major concerns is that MiFID II’s unbundling of research would hurt the ability of small- and medium-sized asset managers to compete against larger asset managers that have adopted the rules.

“Larger firms are better able to absorb some of the costs that they are taking on,  while some of the smaller- and mid-sized firms are struggling to get access they used to get prior to MiFID,” said Sandra Delmore, Global Head of Commission Management, Liquidnet.

In the EU investment firms can either pay for the research out of their own pockets by setting up a research payment account (RPA), funded by commission sharing agreements (CSAs), or direct payment by the client.  Instead of charging their clients, the larger players are absorbing the costs.

While behemoths like BlackRock, Capital Group and T. Rowe Price have said they will pay hard dollars for research for their global clients, small- and medium- sized asset managers feel they are at a disadvantage.

In the U.S., there’s a worry that paying hard dollars for research will become a requirement on request for proposals (RFPs) used by consultants to help pension plans and endowments conduct manager searches.

Noting that TCA has become a big buzz word in RFPs, the buy-side trader predicted that paying for research will become another “check-the-box” requirement for these RFPs. “That’s where it’s going to be a complete competitive disadvantage for a smaller firm,” said they buy-side head trader. If a smaller firm is competing in a bake-off for a small cap growth mandate against a larger player that doesn’t let its clients pay for research, that smaller firm is at a disadvantage, said the trader.

Smaller firms are turning to technology platforms to help them track and manage their research costs and meet their best execution obligations.  Liquidnet offers an end-to-end solution that supports various CSAs to fulfill research obligations and perform trade reconciliations, said Delmore. “It helps firms to automate their entire investment decision making process from setting the budget and making those accurate and explicit targets available for traders using proprietary research and cutting checks to the brokers that would accept them,” said Delmore.

Meanwhile, the U.S. situation is far from settled.

U.S. asset managers are waiting to see if the SEC will allow the no-action letters to lapse or take further action to protect US broker-dealers from disruption and the buy side from absorbing an extra layer of costs.

In March 28 remarks to the SEC Investor Advisory Committee, SEC Chairman Jay Clayton suggested that “some market-based solutions have developed that could make extending the no-action relief unnecessary.” Specifically, Clayton said that some asset managers have addressed the MiFID II unbundling requirement by absorbing the cost of research themselves and having their funds pay their brokers for trade execution services only. Other asset managers have created Research Payment Accounts (RPAs) to budget and track research costs at the fund level, permitting the funds to continue to pay for research through soft dollars and reconciling those payments to ensure compliance with MiFID II.

The main concern is how this will impact the sell side in terms of coverage of small- and mid-cap stocks and the loss of jobs, noted a panelist. Second, if check writing is allowed in the U.S, will this lead to a scenario with four-or-five firms managing money, while smaller firms are forced to close-up shop?  Against this backdrop, the SEC is said to be struggling with a decision, while receiving comment letters from the industry and holding meetings with both the buy and sell side. It remains to be seen how this will pan out.